The Reality of Banking


On March 10th, this tightening cycle claimed its first significant financial industry casualty with the collapse into FDIC receivership of Silicon Valley Bank (SVB), a mid-sized bank located in Santa Clara, California, best known for catering to companies and investors in the technology industry. A small lender to the crypto industry had failed a few days before, but its demise had been explained away as a purely crypto phenomenon and markets had largely ignored it. The collapse of SVB, however, shocked investors. Only days before, SVB had been viewed as a well-capitalized bank with no asset quality problems. Over the subsequent weekend, the FDIC also took over Signature Bank in New York, another bank with ties to crypto. Investors were left to wonder, as markets opened on Monday, were other mid-tier banks at risk? Was this the start of another financial crisis?

As of this writing, even though there has been a shift in deposits away from small and mid-sized banks to larger banks, these bank failures have caused few negative knock-on effects, thanks, in large part, to a swift response from the Fed and the Treasury. Promptly extending the FDIC’s guarantee to cover uninsured deposits and simplifying bank access to emergency borrowing significantly reduced anxiety among depositors and investors alike in the week following SVB’s failure. The most vulnerable banks also received support. UBS was persuaded by the Swiss authorities to rescue Credit Suisse and a $30bn(1) infusion of deposits from major banks looks to have stabilized First Republic Bank. Legislators meanwhile are discussing what to do to stop this kind of thing from happening again.

In trying to assess the likelihood of similar problems occurring with other banks, it is important to remember that SVB was an unusual sort of bank. Its customer base consisted of a close-knit community of venture capitalists and the start-ups they invested in. Large, uninsured deposits accounted for 94%(2) of its deposit base. The bank had seen a large influx of deposits during the pandemic and, since not many of its customers needed loans, and short-term fixed income securities were yielding next-to-nothing, it had parked this money in long duration Treasury bonds. When interest rates rose, SVB suffered a much larger hit to the valuation of its assets than other banks whose assets mostly consist of floating rate loans. When SVB’s interconnected customers realized the bank needed to raise capital, they did the prudent thing uninsured depositors could reasonably do under the circumstances – they demanded their deposits back – all at once.

A good portion of the blame for SVB’s demise also lies with management who did not implement the sort of risk controls standard for a bank of their size. As early as 2019, the Fed had issued citations about the bank’s risk management systems(3). Executives acknowledged the problems but did not move to fix them. In 2022, BlackRock’s consulting arm warned SVB that its risk controls were “substantially below” its peers on 10 of 11 factors considered(4). Again, executives did nothing. For months the bank had no chief risk officer(5).

Risk of recurrence

So, it is certainly possible to argue that SVB was a special case. Here was an institution that had a sudden influx of deposits with nowhere to lend the money, a small group of customers, a hubristic management team, and, most important of all perhaps, a deposit base with no insurance coverage. This vulnerable institution then suffered the sharpest rise in interest rates in a generation from the lowest level anyone can remember. In the end, SVB’s fate was the result of an unfortunate confluence of unusual events overtaking a uniquely positioned bank – not a reason to worry about all banks.

The chances of another similar sort of bank failure are certainly lower now that it has happened once. SVB should have known better than to buy long-dated bonds yielding 1%(6), but at least now other banks know not to do this in the future. Bankers learn the lesson the current crisis is teaching them. In 2008 and 2009 they learned to worry about asset quality. Today they are learning they need to be mindful of interest rate risk. Hopefully, no banker is going to make that mistake again (for a while at least.)

And there are other reasons to believe the risk of recurrence is low. First, stressed banks can now borrow from the Fed on much easier terms using the new Bank Term Funding Program opened on March 12th(7). This program allows banks to borrow against the face value of their collateral instead of the market value – which is how borrowing from the Fed has always worked in the past. This is important because a lot of other banks have the same long-dated Treasury bonds on their balance sheets sitting on the same unrealized losses. The Fed’s promise to lend against the face value of these bonds essentially means that bank executives, investors, and depositors do not need to worry as much about these unrealized losses.

Second, most other banks have much lower levels of uninsured deposits. For the banking system as a whole, uninsured deposits account for about 40% of total deposits(8).

Third, tighter regulation of small- to mid-tier banks is being floated. It is possible therefore that regular stress tests and higher capital and liquidity standards currently in place for larger banks will be implemented for smaller banks. And all these measures can help lower the risk of a bank failure.

So, it seems as though the risk of another SVB-type calamity in the near future is low. But no amount of learning from past failures and stricter rules can eliminate this risk completely. Banking is, at its essence, a confidence trick. Banks take in deposits and then lend most of them out. They keep just a small portion on hand to cover daily withdrawals. If all depositors demand all their money at 9am on a Tuesday, even the strongest bank will be insolvent by noon. The uncomfortable truth is that being at risk of a bank run is just part and parcel of being a bank.

Some weeks have passed now since SVB’s entry into receivership and markets and investors are feeling more relaxed – about the risk of bank failures at least. Not to say that legitimate concerns do not still exist. First Republic Bank continues to look vulnerable and a decline in deposits as a result of customers transferring cash into higher-yielding instruments has caused a swirl of worry around Charles Schwab(9). In addition, although no significant write-downs have been reported yet, it is possible that higher rates could eventually trigger asset quality issues in other areas, such as commercial real estate loans. Nonetheless, contagion, where a run on deposits at one bank triggers runs on deposits at other banks as confidence in the system plummets, seems to have been avoided.

It is always worth remembering, however, that even though the risk of a bank run in the usual course of business is very low indeed, it is not zero. Shareholders should monitor their bank’s balance sheet where assets and liabilities need to be well-diversified. Investors should also satisfy themselves that interest rate risk is being controlled. And depositors should pay attention to FDIC insurance limits. Rules were stretched this time, and almost certainly will be stretched again next time, but best to err on the side of caution.

1. CNN
3. Fox Business News
4. Financial Times
5. Fortune
7. Federal Reserve Board

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